High income-tax rates drive firms into informal sector

This
article examines discrepancies between the number of taxpayers
estimated by Stats SA and the actual numbers reported by SARS. The author believes that people appear to be underreporting their incomes in Stats SA
surveys. If the tax burden for high-income taxpayers goes up, the
economic incentives to disappear into the informal sector will go up with it.

Full article

SOUTH Africans have been led to
believe by Statistics South Africa that the country’s informal sector consists
mainly of retail activity at traffic lights and in spaza shops. According to
Stats SA, employment in the informal sector consists of employees who work for
a small business (employing less than five people) and who are not registered
for income tax (they earn less than R60,000 a year). Of the estimated
2.2-million workers in the informal sector, ostensibly 46% are employed in
retail trade, 15% in personal services and 14% in construction. Stats SA’s data
are almost certainly wrong.

Finance Minister Pravin Gordhan
indicated in last year’s budget speech that there are 6.2-million payers of
income tax in South Africa. Income tax is theoretically assessed on 11-million
people, but 4.9-million fall below the tax threshold, with the result that
income taxes are paid only by 6.2-million people.

This is strange as, according to
Stats SA, there are 13.1-million employees, employers and own-account workers
in South Africa. What accounts for the 2.1-million "missing” taxpayers? Or,
stated differently, why are 16% of income earners not paying income tax?

It is notable that the discrepancy
between the estimate (from Stats SA) and the actual number (from the South
African Revenue Service) of income-taxpayers rises proportionally with reported
income. For example, 102,000 people in the income band above R1m pay income tax
(according to SARS), yet there are only 35,000 people in this band (according
to Stats SA) — a discrepancy of 67,000 people. By comparison, 1.8-million
people in the income band from R60,001 to R160,000 pay income tax (according to
SARS), yet there are as many as 2.8-million people in this band (according to
Stats SA) — a discrepancy of 1-million.

Stats SA does not make proper use of
so-called administrative data (nonstatistical data, such as the number of
income-taxpayers reported by SARS) to adjust the estimates derived from its
sample-based surveys. No serious statistics agency would tolerate the sort of
discrepancies that exist between Stats SA’s data and the administrative data
collected from SARS, the Council for Medical Schemes, the Unemployment
Insurance Fund, The Business Trust and others.

The connection to the informal
sector is this: people appear to be underreporting their incomes in Stats SA
surveys. As a whole, 4.5-million people report to Stats SA enumerators that
they earn income in the taxable range, whereas 6.2-million are actually paying
income tax to SARS — a 27% undercount by Stats SA. Or, put differently, the
average taxpayer’s income is R266,641 a year, according to SARS, and R193,325 a
year according to Stats SA — a 28% undercount.

Without access to additional data,
it is impossible to know to what extent individuals underreport their incomes
to SARS. However, we can come up with a good estimate. For one thing, we know
tax evasion occurs. A recent study by University of Stellenbosch economist
Philip Black suggests that, following the increase of taxes on cigarettes from
12c to 45c a cigarette between 1999 and last year, smuggled cigarettes now
constitute 45% of total cigarette consumption.

SARS and the National Treasury
declined to give us data on fuel taxes, but it is likely that, after the
escalation of fuel taxes on petrol to more than 30% of the official pump price,
the proportion of smuggled petrol in South Africa is now 10%-20%.

Additionally, we know there is a
poor correlation (just 25%) between national income and income-tax revenues.
This implies that the income tax regime in South Africa is complex, as changes
in income explain only a small proportion of changes in the value of income
taxes collected. We also know that income taxes have grown substantially
relative to incomes, which greatly increases the tax burden: 1.7% pay 24.3% of
total income taxes, and 4.5% pay nearly 40%. Both these factors — the
complexity of the income tax regime and the disproportionate incidence of
income tax on people earning more than R600,000 a year — give rise to plenty of
economic incentives to evade taxes.

One available procedure involves
relating income and wealth to the taxes collected on income and wealth. If the
income/wealth of all individuals is known by the tax collector with perfect
certainty, and if income/wealth taxes are collected perfectly efficiently,
there should be a simple relationship between them — the average tax rate. In
order to perform this computation, we collected data on income and wealth taxes
(of households, for example), which is straightforward, as the Reserve Bank
supplies such data. Also, we developed an indirect measure of income and wealth
as wealth, especially, is a highly subjective concept, including as it does
hard-to-measure human capital wealth. Following University of Cape Town
economist Brian Kantor, we used household consumption spending as a proxy for
household income and wealth, and we applied a smoothing procedure to tax
collections, as taxes on income/wealth are very volatile.

There is nowhere near a close
relationship between household income/wealth and taxes on household
income/wealth. The correlation between the two is 71.2%, and this only because
we have smoothed the tax series considerably. Without smoothing, the
correlation is just 12.9%. Moreover, the correlation has not changed to any
appreciable degree between the (apartheid-era) Commission for Inland Revenue
(67.4%) and the (post-apartheid) SARS (69.3%).

We draw two inferences from this.
First, there is tremendous inconsistency in income-tax collection. Using the
level of reported income for the economy as a whole, the authorities know only
vaguely what the level of household income is, and to the extent that they know
it at all, they do so only on average and with three to five years of
hindsight.

Second, the authorities are
collecting only two-thirds to three-quarters of the income taxes owing to them.
Households have succeeded in hiding between a quarter and a third of their
incomes, a figure that has not changed appreciably for the past 50 years.

The implications for our
understanding of the informal sector are significant. According to Stats SA’s
Quarterly Labour Force Survey, 440,000 small-business "closures” occurred
between 2006 and 2011, and the number of new business startups fell to a record
low last year. We put the term "closures” in inverted commas, because it is
likely that these businesses continued to exist and operate but ceased
reporting their activities to the authorities. These enterprises probably
re-emerged in the informal sector, where compliance with income-tax laws is
patchy. It is no coincidence that SARS’s tax amnesty for small businesses and
sole proprietors between 2003 and 2010 netted about 385,000 additional income
taxpayers.

The lesson we draw is that South
Africa’s informal sector consists not only or even primarily of hawkers, but of
a growing number of moderately high-income individuals who, owning their own
businesses, have many options to evade income taxes.

In his recent state of the nation
address, President Jacob Zuma warned tax rates will rise in the coming years.
If, as seems probable, the tax burden for high-income taxpayers goes up, the
economic incentives to disappear into the informal sector will go up with it.
South Africa’s informal sector is growing, largely due to circumvention of
labour laws and evasion of income taxes. In order to stem the growth of
informal economic activity, there is no real alternative but to relax labour
laws and reduce income taxes.

WHY REGISTER WITH SAIT?

Section 240A of the Tax Administration Act, 2011 (as amended) requires that all tax practitioners register with a recognized controlling body before 1 July 2013. It is a criminal offense to not register with both a recognized controlling body and SARS.